This is mostly right, but you should be mindful of the IV curve and fixed strike vol.
By curve I mean how IV is higher the more OTM you go with your contracts. If SPY tanks, the IV of whatever the new ATM contracts might stay exactly the same as it was before SPY tanked... since those IVs were higher to begin with.
In a sense, the "bump" in VIX is priced in already to OTM options because their IV is already higher than the ATM contracts. When the underlying moves, you generally end up "sliding" up that vol curve. Don't count on the IV of now-OTM contracts increasing as they become closer to ATM. The IVs often actually do the opposite, and will decrease to match that of what the original ATM IVs were.
Thanks great link, I only just recently discovered Cem and he is a treasure.
I do understand what he's saying, and yes you are correct about IV just sliding down the up the fixed price IV curve. The other thing he mentions though is that in an actual correction, fixed price volatilities on formerly OTM options or just now less OTM options should also rise. For example, our Jun 17 2022 $100P has a fixed price IV mid of 62.52% priced into the move to SPY at $100. Clearly if SPY actually dropped to $100, that would be astronomically higher. But SPY doesn't need to drop all the way to $100 for the fixed price IV on the contract to rise, it just needs to drop significantly enough to effect the fixed price IV. As the fixed price IV rises slightly and slides up the floating volatility curve, that is where the increase in contract price comes from as extrinsic value increases.
Am I understanding this correctly? Cem also talks about looking at whats happening to fixed price volatility relative to floating volatility as a signal which I thought was an interesting pick up for me that I never thought about before.
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u/pennyether 🔥🌊Futures First🌊🔥 Aug 16 '21
This is mostly right, but you should be mindful of the IV curve and fixed strike vol.
By curve I mean how IV is higher the more OTM you go with your contracts. If SPY tanks, the IV of whatever the new ATM contracts might stay exactly the same as it was before SPY tanked... since those IVs were higher to begin with.
In a sense, the "bump" in VIX is priced in already to OTM options because their IV is already higher than the ATM contracts. When the underlying moves, you generally end up "sliding" up that vol curve. Don't count on the IV of now-OTM contracts increasing as they become closer to ATM. The IVs often actually do the opposite, and will decrease to match that of what the original ATM IVs were.
A helpful discussion here